The Relationship between Corporate Compensation Policies and Investment Opportunities: Empirical Evidence for Large Bank Holding Companies

The existence and determinants of an optimal corporate policy for compensating top executives are unresolved issues in corporate finance. This paper investigates whether the firm's set of investment opportunities drives the amount and type of executive compensation. The firm's investment-opportunity set potentially affects the nature of agency problems between insiders of the firm and outsiders.(1) Examining the empirical relations between compensation schemes and investment opportunities, therefore, may uncover the degree to which executive compensation packages are able to align the incentives of managers and outside security holders.

We conduct a detailed empirical analysis of the executive compensation plans of large bank holding companies (BHCs).(2) Our approach differs from earlier studies that document systematic differences in corporate-compensation policies across industries. Instead, we examine intra-industry changes in compensation policy over a period of significant change in the investment-opportunity set. We study the banking industry because of changes in the set of investment opportunities that occurred in the 1980s.(3) These changes were responses to financial innovation, to the relaxed bank-regulatory constraints, and to deregulation of the financial services industry in general, which have allowed banks to offer nonbanking financial services.

Smith and Watts (1992) contend that, other things equal, the larger the proportion of a firm's value represented by intangible investment opportunities, the greater the manager's compensation should be. They suggest three reasons for this relationship. First, the investment skills of top executives are scarce resources compared to the supervisory skills of executives. Second, since the risk-reward tradeoff applies to executive compensation, the greater the firm's risk, the greater top management's compensation should be. Third, the higher a firm's proportion of intangible assets, the more likely that top management's remuneration is tied to the firm's value through incentive compensation schemes, which would increase the variability of such compensation.

Formal incentive plans usually take the form of bonuses, stock options, stock-appreciation rights, and performance incentive programs. Typically, such programs make an explicit ex ante linkage between the manager's compensation and the firm's performance as measured by stock price, earnings per share, or some other performance measure. The efficacy of such programs results from a direct connection between the manager's actions and the performance measure. Informal incentive programs, in contrast, take the form of ex post settling up. In these cases, for example, the manager's salary is renegotiated based upon the company's performance over some designated period.

Other things equal, firms with substantial growth opportunities and higher future cash flow volatility are more likely to use formal incentive compensation programs for their top executives. Since BHCs face restricted investment opportunities, they are less likely to use formal incentive plans. Smith and Watts (1982) argue that risk-averse managers, who have formal incentive plans, should be more cognizant of risk-return tradeoffs because their compensation risk relates directly to the firm's risk exposure. BHCs' investment opportunities should expand as financial innovation takes place and as regulatory constraints relax. The resulting increase in growth options should be associated with higher levels of total executive compensation because the chief executive officer takes on greater investment responsibilities and greater risks as investment opportunities expand. Further, we should observe a higher incidence of incentive compensation for the chief executive officer because the firm's growth prospects are less restricted.

We find that from 1979 to 1985 total real compensation and the ratio of incentive compensation-to-total compensation increased substantially at regional BHCs but remained stable at money-center BHCs. …

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